Reuven Brenner, McGill University
Obserwator Finansowy: How credible statistical measures of inflation are?
Reuven Brenner: It depends on who is reading them and whether he is taking changes in the regulatory and institutional environment that affects them into account. I will give you a recent good example how devastating effect a misinterpretation of such a statistic may have. Housing is the major (weighting 30%) component of price indices guiding the Federal Reserve and other central banks’ policies. The housing component in price indices relies on rents (to be precise „rent equivalents”), which were stable and not on the prices of homes which did rise. Home prices were going up because people preferred to buy house hoping for a capital gain rather than to pay a rent. Therefore these aggregate indices have been way off the mark.
And nobody took notice of that?
Many observers, including at the Federal Reserve did not notice how legislations and institutions such as Freddie and Fannie that subsidized, directly and indirectly, home ownership changed drastically the nature of this asset class – and the meaning of „inflation rates”. Besides politicians and economists have had their own reason to pursue that policy. They rationalized the subsidies claiming that home-ownership stabilizes communities, give people a stake in the system, and the equity they build can serve subsequently as collateral for starting a business. These observations were accurate as long as the terms „ownership” and „equity” kept their meaning. But – inadvertently – the government’s policies caused losing these meanings. People ended up before the crisis with „ownership” on paper, but with minimal if any equity in the homes. And with no equity in the homes, not only do not any of the presumed benefits of home ownership hold up, but worse: People ended up as renters, with a large, long term debt, which, when mortgage rates rose, they cannot pay – and became homeless.
Most economists and politicians did not realize that these legislations and institutions cause the statistical bureau’s calculation of price indices go awry.
What was result of this mistake?
The resulting CPI calculation (and keep in mind that Greenspan also took out food and fuel, saying that it is the core that he targets, neglecting the impact of the dollar devaluation) – led to the Fed to the wrong conclusion that there was no undue credit expansion. So was the central bank accommodating the creation of too much credit? Absolutely: and the fall of the dollar and rise of gold prices suggested that something was wrong, even though the traditional aggregate statistical measures did not make any alarm signals, and the Federal Reserve has long ago stopped looking at signals emanating from gold prices, Mr. Greenspan’s occasional vague statements to the contrary notwithstanding. Add to the misguided reliance of this aggregate the fact that the Federal Reserve’s mandate (due to the Humphrey-Hawkins’ bill) also has to take into account in its policies another aggregate – the unemployment rate. This too is consequence of another part of the Keynesian outlook, which claimed that there was a stable relationship between inflation and unemployment rates – evidence to the contrary be damned. Not surprisingly the Federal Reserve has neither managed to keep the dollar stable, nor prevent inflation and financial upheavals.
Will attempt to measure and correct the error resulting from changes in the housing sector make sense?
No, because such an attempt one more time will leave us in vicious circle of language and theories that obscure the point. Often people are building Maginot lines, fighting the previous war. We would be improving some statistical aggregate that says very little about changing economic environment.
A few years ago the Federal Reserve did not notice that the shadow banking sector led to a huge credit expansion. Say that today, the Federal Reserve would agree that they will take account housing differently. But suppose that the Fed will continue to disregard gold, resource prices, devaluation of the dollar relative to other currencies (and take out the impact of devaluation from the „inflation rate” it targets). Would that bring a better Fed policy? No.
By the way – there have been heated discussions about whether or not central banks should look at asset prices and shape policies by taking them into account too. This debate missed the main point that statistical aggregates become unreliable when there are drastic changes in laws, regulations, policies and institutions. Once again, the misguided debates and policies were consequence of having been blinded by long-engrained Keynesian thinking and language and utter disregard to details, such as the impact of changing laws and institutions on aggregate measures and their meaning.
Can we trust the examination of the long data series, for example, saying that since the creation of the Federal Reserve in 1913, the dollar lost 98 percent of its value as measured by either the CPI or relative to stabler currencies? Do the long term errors in the data aggregate or cancel out?
You must ask – what is the use of this information for anyone who is not a historian? Keynes wrote many obscure and silly things, but one of his observation was accurate – that in the long run people are dead. So I am not sure who would have an interest in answering the question, and if one does – how would it matter? If the country’s black market is 25 percent or 50 percent, what is the point at all to talk about the unemployment rate and growth rate? Such a black market should bring attention to taxes and regulations that lead people to avoid taxes; to how much people trust their governments in spending prudently, rather than being corrupt. Such focus could be a concrete proposal for economic policy. But long term aggregates?
Consumer Price Index is less than 1 percent. Does it mean the Fed is managing monetary policy well?
No, The Fed still adhere to the silly theories that put us where we are now. It has pumped huge amount of money into the economy, but this does not necessarily translate into credit expansion – it merely supported banks, auto companies – that perhaps would have been better not to. At the same time many growing and innovating companies had no access to credit, as you could see from the widened spread at the time between 5-10 year Treasuries and high-yield bonds. The Fed lends money to banks cheaply, they buy Treasury bonds, and thus allows them to rebuild capital. At the moment we are not dealing with a banking system we have been used to, but rather quasi-governmental agency, used to finance the deficit. The U.S. banking system in this respect got closer to the Chinese one, only there state enterprises are being finance, whereas in the US – banks, car industry, selected infrastructure related business etc. The Fed is pursuing now a fiscal policy in disguise. Federal Reserve lends cheaply money to banks, which they lend back to the government. It is not clear how long this game will go on, but the consequences will be disastrous – for the moment reflected in the devaluation of the dollar.
Devaluation of the dollar? Dollar is very strong.
In recent months against the euro – maybe. But not against other currencies like Swiss franc or yen in the last couple of years. A bit of good luck for the US has been that Greece, Spain, Portugal have been doing big follies of their own – which for the moment stopped the decline in the US dollar. The US had their subprime lending problem Europe has subprime governments given access to credit too cheaply. How long this good luck for the US dollar will last – I do not know. But it is dangerous to rely for too long on the continuous mistakes of strangers. Add to that the demographic revolution taking place, older people giving up on immediate consumption, and saving more for eventual health care and long term care so the traditional measures of inflation no longer offer the right signals in one more respect, since the environment has been changing.
Given these and other distortions that inflation rates published by the statistical offices tell us anything important at all?
Yes, that old ways die hard. It takes very long time to get rid of an erroneous vocabulary once it comes to infest public debates – especially when this vocabulary is used in models that suggests that politicians and academics – with no business experience whatsoever – know how to allocate capital or manipulate prices. I believe I mentioned in a previous interview that your country – and Eastern Europe too should be able to see more clearly the lies behind the Keynesian and aggregates fogs – since they claim to back central planning, So this is a wider problem, and applies not only to price indices, but also aggregates and notions in general that put blinders on policy-makers.
Interview conducted by Krzysztof Nędzyński
Reuven Brenner holds Repap Chair at Desautels Faculty of Management, McGill University. He is the author of among others “Force of Finance: The Triumph of Capital Markets” and “A World of Chance”.